Do Chinese government subsidies affect firm value

Do Chinese government subsidies affect firmvalue?Edward Lee a ,Martin Walker b ,⇑,Cheng Zeng caManchester Accounting and Finance Group,Manchester Business School,Crawford House,Oxford Road,Manchester M139PL,United Kingdomb Manchester Accounting and Finance Group,Manchester Business School,Room 6.21,Harold Hankins Building,Booth Street West,Manchester M139QH,United Kingdom cSchool of Economics,Finance,and Management,University of Bristol,Social Sciences Complex,8Woodland Road,Clifton BS81TN,United Kingdoma b s t r a c tConsistent with the prevailing socio-political ideology of China,the Chinese government offers financial assistance to firms,including many listed ernment subsi-dies are provided for several reasons including support for investment,support to enable firms to pursue social objectives,and support to prop up ailing firms in order to protect jobs.We examine the value relevance of government subsidies for Chinese listed companies and structure our study around three questions.First,whether the subsidies received by Chinese listed companies are value relevant consistent with their time-series properties.Second,whether the value relevance of subsidies depends on the purpose for which they are used.Third,whether the value relevance of subsidies depends on the channel through which they are granted.We motivate these research questions through interviews of accountants,managers,aca-demics,government officials and financial analysts.Through large sample analyses,we confirm that subsidies are positively related to firm value,but less so for distressed firms and subsidies granted through non-tax channels.Our study contributes to improved understanding of Chinese-style capitalism.Ó2014Elsevier Ltd.All rights reserved.IntroductionChina is playing an increasingly important role in the global economy,and is expected to surpass the US to be-come the world’s largest economic power (Hawksworth &Tiwari,2011).An interesting feature of Chinese listed firms,that distinguishes them from their Western peers,is the pervasiveness of their access to financial subsidies from the government.Despite over three decades of trans-formation from a centrally planned to a market-oriented economy (Ezzamel,Xiao,&Pan,2007),the Chinese govern-ment (both central and local levels)maintains a high de-gree of influence on listed firms through such practices (Allen,Qian,&Qian,2005).In recent years,however,there is increased international concern that state subsidies are giving Chinese firms an unfair advantage over foreign com-petitors (Capital Trade Incorporated,2008).These reasons call for a better understanding of the effects of Chinese state subsidies.The main purpose of this paper is to examine the link between firm value and Chinese government subsidies.Since state subsidies capture the government’s ‘‘visible hand’’,a study of the value relevance of subsidies for Chi-nese listed firms provides an opportunity to examine the direct role of government in the economy.Although sev-eral studies have investigated the value relevance of accounting numbers in China (e.g.Bao &Chow,1999;Chen,Chen,&Su,2001;Sami &Zhou,2004),there has been little systematic examination of how subsidies are re-flected in the market value of Chinese listed companies./10.1016/j.aos.2014.02.0020361-3682/Ó2014Elsevier Ltd.All rights reserved.Corresponding author.Tel.:+4401612754008;fax:+4401612754023.E-mail address:martin.walker@ (M.Walker).Moreover,most existing studies on the value relevance of accounting information in China fail to model the underly-ing information dynamics,which prevents them from con-sidering whether the accounting numbers are rationally valued.Thus,we explore this issue by using large scale sta-tistical data to estimate accounting based models offirm value based on the ideas in Ohlson(1995,1999).However,before undertaking this statistical analysis we first engaged in a number of interviews of people actively involved in the granting and receiving of subsidies(e.g. government officials and entrepreneurs)as well as people with expertise on this issue(e.g.accountants,academics, andfinancial analysts).The interviews were used to gain a better understanding of why the market value of subsi-dies might vary across different contexts.Based on the re-sult of the interviews,we structure our econometric analyses of the valuation consequence of state subsidies around the following three questions.First,we investigate whether the subsidies received by Chinese listed companies are value relevant and,if so,is the value relevance of subsidies consistent with their time-series properties?Following the approach of Barth, Hand,and Landsman(1999)and Landsman,Miller,and Yeh(2007),which extend the Ohlson(1999)model,we find that subsidies are value relevant on average,consis-tent with the results of our analyses of their information dynamics.This is also consistent with subsidies being viewed as beneficial from the perspective of outside equity investors.Second,we investigate whether subsidies are equally value relevant across allfirm contexts.In particular,does the value relevance of subsidies differ if they are used to boostfirms’competitiveness or to bailoutfirms in trouble? We partition the sample intofinancially healthy and dis-tressedfirms and our analyses indicate that subsidies are value relevant for the former group,but not the latter group.This is consistent with subsidies not adding value to thefirm if they are likely to be used to assist earnings management or impede natural selection against weak firms.Third,we consider if the value relevance of subsidies depends on the channel through which they are granted. We classify subsidies into those based on tax rebates and those provided by non-tax approaches such as direct cash payments,loan guarantees,and debt forgiveness.Our anal-yses reveal that the valuation consequence of subsidies dif-fers considerably between the two different channels.In particular,wefind that the value relevance of tax based subsidies is substantially greater than that of non-tax based subsidies,which is consistent with the former being granted on a more persistent and transparent basis.Ourfindings have implications for academics,policy makers,andfirms.From an academic point of view,we show that it is possible to use accounting based valuation models to demonstrate the valuation consequence of state subsidies.This research methodology also enables us to show that value relevance varies in predictable ways according to the purpose and channel of the subsidies. For policy makers,our evidence implies that subsidies are an essential input to the valuation decisions of inves-tors in Chinese listedfirms and policies that ensure their clear disclosure should be promoted.As such,our study also offers policy implications for Chinese capital market regulators,who are keen to enhance transparency and information efficiency.1For thefirms,our study suggests that the Chinese capital market recognizes that state subsi-dies provide net benefits to corporate value.Thus we have identified a valuation driver specific to the context of China, whichfirms should consider as part of their effort to maxi-mize their shareholders’wealth.The remainder of the paper is organized as follows:‘Lit-erature review and institutional background’briefly re-views the economic literature on the role of subsidies in the development of the economy and introduces the insti-tutional environment in China.‘Interviews and hypotheses development’presents thefindings of our interviews,and develops our main research hypotheses.‘Modeling the va-lue relevance of government subsidies’describes the re-search design and sample selection process.‘Empirical results’presents the econometric evidence and the last section concludes.Literature review and institutional background Related economic literatureSubsidies are economic intervention tools used by gov-ernments around the world to offset market imperfections, to exploit economies of scale,and to pursue social policy objectives(Schwartz&Clements,1999).For instance,a government may offer subsidies tofirms to influence re-search and development(R&D)(González,Jaumandreu,& Pazo,2005;Gorg&Strobl,2007;Irwin&Klenow,1996), export competitiveness(Desai&Hines,2008;Ishikawa& Spencer,1999;Shivakumar,1993),production efficiency (Azzimonti,de Francisco,&Krusell,2008;Bagwell&Stai-ger,1989,2006),wages and employment(De Mel,McKen-zie,&Woodruff,2010;Phelps,1994;Snower,1994),and environmentally friendly practices(Conrad,1993;Conrad &Wang,1993;Kohn,1997).However,existing empirical research on the economic effects of state subsidies yields a mixed picture.On the one hand,some studies suggest that subsidies can stimulate R&D activities(Almus&Czar-nitzki,2003;Davidson&Segerstrom,1998;González et al., 2005),improvefirm profitability(Desai&Hines,2008;Gir-ma,Gong,Gorg,&Yu,2009),enhance competitiveness (Bagwell&Staiger,1989;Brander&Spencer,1985),and reduce the capital constraints offirms(Claro,2006;Li, 2002).On the other hand,some studies suggest that subsi-dies result in overproduction or efficiency losses(Larsen& Shah,1992;Lopez&Galinato,2007;To,1994),and invite international disputes(e.g.Neary,1994).In recent years, the increased outcry of the US government against Chinese state subsidies tofirms(Capital Trade Incorporated,2008) suggests that subsidies may distort competitiveness and disadvantage USfirms against their Chinese counterparts. 1These issues were mentioned,for instance,in the Chinese Capital Markets Development Report issued by the China Security Regulatory Committee(CSRC)in2007to discuss the future of China’s stock market development:/pub/csrc_en/Informations/publica-tion/200911/P020091103520222505841.pdf(in Chinese).150 E.Lee et al./Accounting,Organizations and Society39(2014)149–169The role of government in transitional economies, which are evolving from centrally planned socialism to market-oriented capitalism,is widely debated in the eco-nomic literature.In terms of process,the literature puts forward the‘‘big bang’’and sequential reform approach. The‘‘big bang’’approach argues that reforms should be carried out quickly(Balcerowicz,1995;Lipton&Sachs, 1990)so as to create irreversibility(Boycko,Shleifer,& Vishny,1995)and exploit the window of opportunity.This was adopted by the Eastern European and former Soviet Union countries through mass privatization to overcome political constraints(Shleifer&Treisman,2000).The sequential reform approach suggests a gradual process to build upon the successes of previous stages in order to gen-erate incentives for further changes(Dewatripont&Ro-land,1995;Litwack&Qian,1998;Wei,1997).This was implemented in China through a gradual liberalization process(Lau,Qian,&Roland,2000).In terms of govern-ment behavior in transitional economies,the existing liter-ature studies the‘‘grabbing hand’’and‘‘helping hand’’approaches(e.g.Frye&Shleifer,1997).The former portrays government as controlled by officials that do not maximize social welfare and pursue their own selfish objectives (Shleifer&Vishny,1998),and is associated with local gov-ernments such as Russia and Poland(Shleifer&Vishny, 1993).The latter is often associated with the case of China (Che&Qian,1998;Walder,1995),where the government seeks to guide or stimulate economic growth by reallocat-ingfinancial resources.In terms of outcome,most transi-tional economies experience an initial drop in output, which is then followed by a recovery of varying paces (Hellman&Shankerman,2000).China is an interesting exception to this pattern since it began with high growth immediately without the early stage recession(Roland, 2002).Inter-jurisdictional competition among local govern-ments is an important feature of state intervention in the economy.Earlier literature suggests that competition among regions is beneficial because it helps satisfy regio-nal demand(Oates,1972),improve governance(Brennan &Buchanan,1980),and reduce resource allocation distortions(Qian&Roland,1998).More recent literature suggests competition among regions may cause problems such as the depletion of local government revenues (Keen&Marchand,1997)and thefixation of local gov-ernment on business interests(Bardhan&Mookherjee, 2000).Empirical studies report mixed results,with the influence of local government competition on growth in China being positive but in Russia being negative(Jin, Qian,&Weingast,2005;Zhuravskaya,2000).One possi-ble reason for this contrast is the difference in the degree of political centralization between the two transitional economies(Enikolopov&Zhuravskaya,2007).In Russia, the central government was ineffective in disciplining local government officials against self-serving policies that would impose negative externalities on the rest of the country(Shleifer&Treisman,2000).In China,local government officials are more disciplined due to political career advancement concerns as a result of the effective control of a single political party across the entire country.Institutional settingThe growing interest among academics,policy makers, and practitioners in Chinese-style capitalism stems from China’s increasingly important position in the world econ-omy.2China’s stock market began with the opening of the stock exchanges in Shanghai and Shenzhen back in the early 1990s to facilitate economic reform.It subsequently grew to become the largest developing economy by2001,and the world’s5th largest economy,in terms of market capitaliza-tion,by2010.3The overwhelming majority of the listed firms are former state-owned enterprises(SOE)in which the government retained a majority ownership following their initial public offering(IPO)(O’Connor et al.,2004). For Chinesefirms having a stock market listing is important both for capital acquisition purposes,and for the purpose of international visibility.Unlike Western developed economies,the Chinese stock exchanges impose delisting rules that influence the allocation of market capital.The China Security Regulatory Committee(CSRC)mandates that if a listedfirm reports losses in two consecutive years,its stock will be classified as specially treated(ST)and face many trading andfinan-cial restrictions.For suchfirms,the daily stock price move-ment is restricted within a range of5%,the semi-annual report must be audited,and raising additional capital from the stock market is prohibited.If an STfirm reports one more year’s loss,then its stock is suspended from trading on the stock exchanges,and after a fourth annual loss the stock is delisted.To avoid these restrictions or delisting,firms manipulate earnings in order to avoid reporting losses and state subsidies may be used to achieve this pur-pose(Chen,Lee,&Li,2008).Subsidies from the government are an important re-source for Chinesefirms.4Based on Chinese Accounting Standards(2006),government subsidies are defined as mon-etary or non-monetary assets obtained freely by an enter-prise from the government,but excluding the capital invested by the government as the partial owner of the enterprise.5According to state policy,the primary goal of subsidies is to develop national priority areas such as agri-culture,public utilities,and high-tech industries(Chen et al.,2008;Girma et al.,2009).In addition,the governments may also provide subsidies to helpfirms overcome capital constraints and to aidfirms infinancial difficulties(Claro, 2006).6Chinese SOEs receive more subsidies on average rel-ative to privately controlledfirms,because the government makes use of them to pursue socio-political objectives such 2Appendix A compares the economy of China as of2009against developed G7countries(Panel A)and other major emerging economies (Panel B).3The statistics can be found at:/2011/ 09/worlds-top-5-stock-exchanges.html.4Allen et al.(2005)suggest that state subsidies are one of the four most importantfinancial sources of Chinesefirms,along with bank loans,firms’self-fundraising,and foreign direct investment.5Chinesefirms report state subsidies as one of the below-the-line items infinancial statements.State subsidies were reported as an independent item before2007,and included as part of the‘‘other revenues’’item afterwards.6We use the word‘‘governments’’here because both central and regional governments provide subsidies.E.Lee et al./Accounting,Organizations and Society39(2014)149–169151as creating job opportunities and stabilizing local economies (e.g.Hung,Wong,&Zhang,2008;Lee,2001;O’Connor et al., 2006).Subsidies can be granted by both central and local governments(Thomas,1994),although such powers are increasingly delegated to local government officials who have a better understanding of their regional development needs.Thisfiscal decentralization also induces competition among local governments to offer subsidies since the num-ber offirms under their jurisdiction is viewed as a perfor-mance indicator of the officials.State subsidies can be broadly categorized into tax and non-tax based.Tax based subsidies are mainly granted through rebates of value added tax and export tax to encourage prioritized regions,sectors,and projects.Firms become eligible for tax rebates if they are located in special economic zones or if they invest in projects and/or operate in sectors prioritized by government policies.As such,the receipt of tax base subsidies may signal that afirm has bet-ter prospects or reduced risks.The non-tax based subsidies are offered as direct cash payments,loan guarantees,and debt ernment officials grant non-tax based subsidies on a more discretionary and subjective basis.As such,the receipt of non-tax based subsidies is more a reflection of political favoritism rather than afirm’s poten-tial.These differences in the implication of tax and non-tax based subsidies are expected to influence investors’deci-sions on the valuation of the recipientfirms.The value relevance of accounting information has been widely studied in the Western accounting literature.7For instance,Landsman et al.(2007)find that earnings and book values explain around64.3%of the variation in market value of USfirms over the period of1990–2000.Barth et al.(2001) argue that value relevance evidence is important to account-ing standard setters since one of the primary purposes of financial reporting is to provide information useful for valu-ingfirms.In the emerging economies such as China,the lit-erature on the value relevance of accounting information is more limited.Existing studies on this issue in China(Chen &Wang,2004;Chen et al.,2001;Haw,Qi,&Wu,1999)con-sistently show that the earnings information is incorporated into investors’valuation of listedfirms.8For instance,over the sample period of1995–1998,Chen et al.(2001)find that earnings and book value explain around25%of the variation in market value of their sample.To the best of our knowl-edge,Chen and Wang(2004)is the only prior study to con-sider the effect of government subsidies on the valuation of Chinese listedfiing a sample for1997–2000,they find no evidence that subsidies are value relevant despite theirfinding that it is the most persistent below-the-line item.However,given the importance of state subsidies in the context of Chinese listedfirms and the rapid change of Chinese economy,their value relevance deserves to be stud-ied using a longer and more recent period sample.Interviews and hypotheses developmentInterview designTo gain a better understanding of Chinese government subsidies policy and to motivate our hypotheses for the large sample econometric analyses,we carried out12inter-views of people familiar with this issue.The interviews were held over the telephone and varied in length,ranging from20min to50min.Based on existing literature(e.g. Chen&Li,2001;Chen et al.,2008;Tang&Luo,2007;Zhu &Chen,2009)and anecdotal evidence,a pre-determined interview protocol was designed which included a set of open-ended questions.Appendix B provides further details on these questions.We were aware that some of our ques-tions are politically sensitive,and that some of the intervie-wees may have been reluctant to respond to such questions because of their position.We addressed this issue in several ways:First,we reserved the‘‘more controversial’’questions for later in the interview,consistent with Sudman and Bradburn(1983).Second,we tried to ask the questions tact-fully.Third,we assessed some answers through the tone of the interviewees such as‘‘very likely’’,‘‘hard to say’’,or‘‘the possibility cannot be excluded’’.Finally,to ensure the accu-racy of the responses,we conducted additional checks to confirm the answers until the interviewees verified our understanding of their responses.Our selected interviewees consist of twelve people who are familiar with government subsidies in China.They include government officials,accountants,entrepreneurs,academics, and analysts,who are based in cities like Beijing and Chongq-ing,or provinces such as Shandong and Shaanxi.Appendix C Panel A presents the details of interviewees and the date of their interviews.The interviews themselves were undertaken by our Chinese co-author.The analysis of the interviews was conducted by all three authors.The interview questions were initially designed in English.Because the interviewees are all native Chinese speakers,the questions were asked and the an-swers were recorded in Chinese(Mandarin).Finally,the Chi-nese co-author translated the Chinese answers into English.Interview resultsWhat conditions mustfirms meet to obtain government subsidies?The most commonly noted reason for Chinese govern-ments to provide subsidies is to encourage the develop-ment of specific businesses or industries.This was cited by nine of interviewees.In other words,the businesses or industries that the Chinese government prefers to promote growth are more likely to receive subsidies.The response from one of the accountants illustrated this point:‘Forfirms to qualify for subsidies,their research and development expenses must exceed a given threshold, or their products must be within the high technology fields as stipulated in official guidelines.’Another important consideration that influences whether or notfirms receive subsidies is the personal con-nections(or guanxi)between entrepreneurs and officials.7For more literature review on this topic,see Barth,Beaver,andLandsman(2001).8These studies examine the relevance of accounting information to thevalue of domestic shares(also known as A-shares),which are issued by vastmajority of Chinese listedfirms.Other studies such as Bao and Chow(1999)and Sami and Zhou(2004)focus on a smaller group of Chinese listedfirmsthat also issue foreign shares(also known as B-shares),and producebroadly similarfindings that earnings are value relevant.152 E.Lee et al./Accounting,Organizations and Society39(2014)149–169This is especially true for the non-tax based subsidies such as direct cash grants,loan guarantees,and debt forgive-ness.For instance,one of the entrepreneurs from Shandong province suggested that:‘If the local government has budget limitations,then the politically connected producers are more likely to be subsidized than their non-connected peers.’How often dofirms receive subsidies from governments?A majority of interviewees stated that the frequency of receiving subsidies varies across industries as well as the type of projects thefirms used for application.This was ci-ted by six of the interviewees.One of the entrepreneurs from Shandong province suggested that the frequency may depend on the channel of subsidies granted:‘When the subsidies are received in a form of non-tax rebates,it is likely to be less persistent because such form of subsidies is often based on occasional budgets, which in turn is affected by the availability offinancial resource of the government.’As to the question whether central or local government provides subsidies more frequently,most of the intervie-wees who answered this question chose the former.This was cited byfive of the six interviewees,while the remain-ing four did not provide a clear answer.The official from Chongqing explained this issue from the perspective of governments:‘The central government provides subsidies more fre-quently than local governments because the former manages much morefiscal resources.’Which kind of subsidies is more likely to be fair and less subjective?Most of the participants of our interviews agreed that tax based subsidies are granted on a more objective basis and are less likely to be influenced by the discretion of gov-ernment officials.This was cited by eight of the intervie-wees.For instance,the entrepreneur from Chongqing also suggested that:‘Tax based subsidies are relatively more transparent and the application procedure is also easier than for other forms of subsidies.’Interestingly,all three officials we interviewed did not deny that non-tax based subsidies can be less fair and more obscure.The comments from the Chongqing official were especially insightful:‘Because thefiscal resources of local governments can be limited,firms eligible for non-tax subsidies must be further selected and this process can involve a cer-tain degree of subjectivity.’What are the costs and benefits of subsidies?From thefirms’point of view,government subsidies are an extra source of funding that helps them increase their earnings.Moreover,subsidies also bring along reputational benefits to the recipientfirms.For example,the Chongqing entrepreneur commented that:‘Receiving subsidies imply that thefirms have promis-ing projects endorsed by the government.The subsidies not only assist thefirmsfinancially when developing the products,but the reputational benefit they bring along also helps thefirms promote the sales of these products.’Of course,to qualify for government subsidies,the crite-ria often requirefirms to make initial investments such as equipment,staff,and other expenses.Furthermore,as mentioned earlier,personal networking and political con-nections often improve the chances offirms receiving sub-sidies.Thus,initial investment and human capital are prerequisites of qualifying for subsidies.One of the entre-preneurs from Shandong province weighed the benefit against the cost of subsidies:‘To qualify for subsidies,firms may have to bear the cost of initial investment as well as human capital.However, benefits of government support should outweigh these costs in the long run.’What are the governments’objectives in providing subsidies?There are mixed responses across the interviewees over the question of whether or not the rescue of distressed firms is one of the objectives of the government to offer subsidies.The Chongqing official suggested that:‘One reason for aiding distressedfirms is that their bankruptcy may have substantial influence on local economy or social stability through employment.How-ever,this is carried out on a case by case basis.’When asked if distressedfirms are able to receive tax based subsidies,the officials from Shandong province and Chongqing gave positive answers.For example,the former noted that:‘Whether or not afirm is eligible for tax rebates has lit-tle to do with whether it is profitable or not.The key point is that thefirm must satisfy the government pol-icies designed for tax based subsidies.’Do subsidies really matter in analysts’earnings forecast, target price forecast,and stock recommendations?Both of the analysts agreed that subsidies information is useful for them to anticipatefirms’earnings,target prices, or make stock recommendations.One of the analysts men-tioned that:‘We pay more attention to subsidies if it accounts for a higher percentage of afirm’s revenue.We also forecast the changes in national policies on subsidies.’As to the question of whether subsidies are more useful for analysts to forecast earnings,target prices,or make rec-ommendations forfinancially healthyfirms than distressed firms,both analysts provided consistently positive an-swers.One of them explained that:E.Lee et al./Accounting,Organizations and Society39(2014)149–169153。